2Economics The Basics When wants exceed the resources available to satisfy them, there is scarcity. Faced with scarcity, people must make choices. Economics is the study of the choices people make to cope with scarcity. Choosing more of one thing means having less of something else. The opportunity cost of any action is the best alternative forgone. 3The Basics (Cont..) Microeconomics - The study of the decisions of people and businesses and the interaction of those decisions in markets. The goal of microeconomics is to explain the prices and quantities of individual goods and services. Macroeconomics - The study of the national economy and the global economy and the way that economic aggregates grow and fluctuate. The goal of macroeconomics is to explain average prices and the total employment, income, and production. Positive statements - Statements about what is. Normative statements - Statements about what ought to be. Ceteris paribus - Other things being equal or if all other relevant things remain the same. 4The Basics (Cont..) The fallacy of composition - What is true of the parts may not be true of the whole. What is true of the whole may not be true of the parts. The post hoc fallacy - The error of reasoning from timing to cause and effect. Economic efficiency - Production costs are as low as possible and consumers are as satisfied as possible with the combination of goods and services that is being produced. Economic growth - The increase in incomes and production per person. It results from the ongoing advance of technology, the accumulation of ever larger quantities of productive equipment and ever rising standards of education. Economic stability - The absence of wide fluctuations in the economic growth rate, the level of employment, and average prices. 5The Modern economy Economy - A mechanism that allocates scarce resources among alternative uses. This mechanism achieves five things What, How, When, Where, Who. Decision makers - Households, Firms, Governments. Household - Any group of people living together as a decision-making unit. Every individual in the economy belongs to a household. Cont 6Firm - An organization that uses resources to produce goods and services. All producers are called firms, no matter how big they are or what they produce. Car makers, farmers, banks, and insurance companies are all firms. Government - A many-layered organization that sets laws and rules, operates a law-enforcement mechanism, taxes households and firms, and provides public goods and services such as national defense, public health, transportation, and education. Market - Any arrangement that enables buyers and sellers to get information and to do business with each other. 7Role of Government Not so very long ago, economic planning and public ownership of the means of production were the wave of the future. Planners cannot find out what needs to be done to co-ordinate the production of a modern economy. Even if a technically feasible plan could be drawn up, there is no reason to believe it will be implemented. How could a central planner know better than the consumers what the individual woman wants? Planners can only provide users with what they believe they should want. Because prices bear no relation to costs, there is no way to calculate what production needs to increase and what production needs to be reduced. Cont. 8The state has three functions To provide things - known as public goods - that the market cannot provide for itself To internalize externalities or remedy market failures To help people who, for a number of reasons, do worse from the market or are more vulnerable to what happens within it than society finds tolerable. In addition to providing public goods, governments directly finance or provide certain merit goods. Such goods are consumed individually. But society insists on a certain level or type of provision. The role of the state in a modern market economy is, in short, pervasive. The difference between poor countries and richer ones is not that the latter do less, but that what they do is better directed (on the whole) and more competently executed (again, on the whole). Cont. 9The first requirement of effective policy is a range of qualities credibility, predictability, transparency and consistency. The more the government focuses on its essential tasks and the less it is engaged in economic activity and regulation, the better it is likely to work and the better the economy itself is likely to run. If one needs a large number of bureaucratic permissions to do something in business, the officials have an opportunity to demand bribes. Once it is known that a government is prepared to create such exceptional opportunities, there will be lobbying to create them. Then there is not just the corruption of the government, but the waste of resources in such 'rent-seeking' or 'directly unproductive profit-seeking activities'. Governments are natural monopolies over a given territory. One of the strongest arguments for an open economy is that it puts a degree of competitive pressure on government. Cont. 10Factors of Production Factors of production - The economys productive resources Labor, Land, Capital, Entrepreneurial ability. Land - Natural resources used to produce goods and services. The return to land is rent. Labor - Time and effort that people devote to producing goods and services. The return to labour is wages. Capital - All the equipment, buildings, tools and other manufactured goods used to produce other goods and services. The return to capital is interest. Entrepreneurial ability - A special type of human resource that organizes the other three factors of production, makes business decisions, innovates, and bears business risk. Return to entrepreneurship is profit. 11Economic Coordination Markets - Coordinate individual decisions through price adjustments. Command mechanism - A method of determining what, how, when, and where goods and services are produced and who consumes them, using a hierarchical organization structure in which people carry out the instructions given to them. Market economy - An economy that uses a market coordinating mechanism. Command economy - An economy that relies on a command mechanism. Mixed economy - An economy that relies on both markets and command mechanism. 12Production Possibility Frontier The quantities of goods and services that can be produced are limited by the available resources and by technology. That limit is described by the production possibility frontier. Production Possibility Frontier (PPF) - The boundary between those combinations of goods and services that can be produced and those that cannot. Production efficiency - When it is not possible to produce more of one good without producing less of some other good. Production efficiency occurs only at points on the PPF. Economic growth - Means pushing out the PPF. The two key factors that influence economic growth are technological progress and capital accumulation. Cont.. 13Technological progress - The development of new and better ways of producing goods and services and the development of new goods. Capital accumulation - The growth of capital resources. Absolute Advantage - If by using the same quantities of inputs, one person can produce more of both goods than some one else can, that person is said to have an absolute advantage in the production of both goods. Comparative Advantage - A person has a comparative advantage in an activity if that person can perform the activity at a lower opportunity cost than anyone else. 14

Law of Demand

Demand curve - Shows the relationship between the quantity demanded of a good and its price, all other influences on consumers planned purchases remaining the same.

Other things remaining the same, the higher the price of a good, the smaller is the quantity demanded.

Substitution effect

Income effect.

As the opportunity cost of a good increases, people buy less of that good and more of its substitutes.

Faced with a high price and an unchanged income, the quantities demanded of at least some goods and services must be decreased.

Cont.

15Substitute - A good that can be used in place of another good. Complement - A good that is used in conjunction with another good. Normal goods - Goods for which demand increases as income increases. Inferior goods - Goods for which demand decreases as income increases. If the price of a good changes but everything else remains the same, there is a movement along the demand curve. If the price of a good remains constant but some other influence on buyers plans changes, there is a change in demand for the good. A movement along the demand curve shows a change in the quantity demanded and a shift of the demand curve shows a change in demand. 16

Law of Supply

Law of supply Other things remaining the same, the higher the price of a good, the greater is the quantity supplied.

Supply of a good depends on

The price of the good

The prices of factors of production

The price of other goods produced Expected future prices

The number of suppliers

Technology.

Cont

17Supply curve - Shows the relationship between the quantity supplied and the price of a good, everything else remaining the same. If the price of a good changes but everything else influencing suppliers planned sales remains constant, there is a movement along the supply curve. If the price of a good remains the same but another influence on suppliers planned sales changes, supply changes and there is a shift of the supply curve. A movement along the supply curve shows a change in the quantity supplied. The entire supply curve shows supply. A shift of the supply curve shows a change in supply. 18Equilibrium Equilibrium A situation in which opposing forces balance each other. Equilibrium in a market occurs when the price is such that the opposing forces of the plans of buyers and sellers balance each other. The equilibrium price is the price at with the quantity demanded equals the quantity supplied. The equilibrium quantity is the quantity bought and sold at the equilibrium price. When both demand and supply increase, the quantity increases. The price may increase, decrease, or remain constant. When both demand and supply decrease, the quantity decreases. The price may increase, decrease, or remain constant. When demand decreases and supply increases, the price falls. The quantity may increase, decrease, or remain constant. When demand increases and supply decreases, the price rises and the quantity increases, decreases, or remains constant. 19Elasticity The total revenue from the sale of a good equals the price of the good multiplied by the quantity sold. An increase in price increases the revenue on each unit sold. But an increase in price also leads to a decrease in the quantity sold. Whether the total expenditure increases or decreases after a price hike, depends on the responsiveness of demand to the price. Price elasticity of demand A measure of the responsiveness of the quantity demanded of a good to a change in its price, other things remaining the same. It is the percentage change in demand divided by percentage change in price. Cont 20Inelastic demand - If the percentage change in the quantity demanded is less than the percentage change in price, then the magnitude of the elasticity of demand is between zero and 1, and demand is said to be inelastic. If the quantity demanded remains constant when the price changes, then the elasticity of demand is zero and demand is said to be perfectly inelastic. Elastic demand - If elasticity is greater than 1, it is elastic. If the quantity demanded is indefinitely responsive to a price change, then the magnitude of the elasticity of demand is infinity, and demand is said to be perfectly elastic. 21When markets do not work Price ceiling - A regulation that makes it illegal to charge a price higher than a specified level. When a price ceiling is applied to rents in housing markets, it is called a rent ceiling. Black market - An illegal trading arrangement in which buyers and sellers do business at a price higher than legally imposed price ceiling. Minimum wage law - A regulation that makes hiring labor below a specified wage illegal. Externalities Social costs, but no private costs. 22

Consumption Utility

A households consumption choices are determined by

Budget constraint

Preferences.

Utility - The benefit or satisfaction that a person gets from the consumption of a good or service.

Total utility - The total benefit or satisfaction that a person gets from the consumption of goods and services.

Marginal utility - The change in total utility resulting from a one-unit increase in the quantity of a good consumed.

Consumer equilibrium - A situation in which a consumer has allocated his or her income in the way that, given the prices of goods and services, maximizes his or her total utility.

23Understanding Costs Short run - Period of time in which the quantity of at least one input is fixed and the quantities of the other inputs can be varied. Long run - Period of time in which the quantities of all inputs can be varied. Inputs whose quantity can be varied in the short run are called variable inputs. Inputs whose quantity cannot be varied in the short run are called fixed inputs. Firms total cost - The sum of the costs of all the inputs it uses in production. Fixed cost -The cost of a fixed input. Variable cost - The cost of a variable input. Total fixed cost - The total cost of fixed inputs. Cont 24Total variable cost - The cost of the variable inputs. Marginal cost - The increase in total cost for increasing output by one unit. Average fixed cost (AFC) - Total fixed cost per unit of output. Average variable cost (AVC) - Total variable cost per unit of output. Average total cost (ATC) - Total cost per unit of output. Long-run average cost curve - Traces the relationship between the lowest attainable average total cost and output when both capital and labor inputs can be varied. Economies of scale - As output increases, long-run average cost decreases. Diseconomies of scale - As output increases, long run average cost increases. 25Perfect Competition There are many firms, each selling an identical product. There are many buyers. There are no restrictions on entry into the industry. Firms in the industry have no advantage over potential new entrants. Firms and buyers are completely informed about the prices of the product of each firm in the industry. Firms in perfect competition are said to be price takers. A price taker is a firm that cannot influence the price of a good or service. 26Imperfect Competition Monopoly - An industry that produces a good or service for which no close substitute exists and in which there is one supplier that is protected from competition by a barrier preventing the entry of new firms. Price discrimination - The practice of charging some customers a lower price than others for an identical good or of charging an individual customer a lower price on a large purchase than on a small one, even though the cost of servicing all customers is the same. Monopolistic competition - A market structure in which a large number of firms compete with each other by making similar but slightly different products. Oligopoly - A market structure in which a small number of producers compete with each other. 27Business Cycles Trends and cycles Economic developments should be judged in the context of trends and cycles. Trends - The trend is the long-term rate of economic expansion. Cycles - The cycle reflects short-term fluctuations around the trend. There are always a few months or years when growth is above trend, followed by a period when the economy contracts or grows below trend. Long-term growth - In the long term the growth in economic output depends on the number of people working and output per worker. Output per worker grows through technical progress and investment in new plant, machinery and equipment. Investment and productivity are therefore the basis for continued and sustained economic expansion. Recession - A period during which real GDP decreases the growth rate of real GDP is negative for at least two successive quarters. Cont. 28Consumption expenditure - The amount spent on consumption goods and services. Saving is the amount of income remaining after meeting consumption expenditures. Savings What remains out of income after consuming. Capital - The plant, equipment, buildings, and inventories of raw materials and semi-finished goods that are used to produce other goods and services. The amount of capital in the economy is a crucial factor that influences GDP growth. Investment - The purchase of new plant, equipment, and buildings and the additions to inventory. Investment increases the stock of capital. Depreciation is the decrease in the stock of capital that results from wear and tear and the passage of time. Cont 29 Government Purchases - Governments buy goods and services, called government purchases, from firms. Net taxes - Taxes paid to governments minus transfer payments received from governments. Transfer payments - Cash transfers from governments to households and firms such as social security benefits, unemployment compensation, and subsidies. 30Measuring Economic Activity Total economic activity may be measured in three different but equivalent ways. Add up the value of all goods and services produced in a given period of time, such as one year. Money values may be imputed for services such as health care which do not change hands for cash. Since the output of one business (for example, steel) can be the input of another (for example, automobiles), double counting is avoided by combining only "value added", which for anyone activity is the total value of production less the cost of inputs such as raw materials and components valued elsewhere. A second approach is to add up the expenditure which takes place when the output is sold. Since all spending is received as incomes, a third option is to value producers' incomes. Cont 31Gross domestic product - GDP is the total of all economic activity in one country, regardless of who owns the productive assets. For example, Indias GDP includes the profits of a foreign firm located in India even if they are remitted to the firm's parent company in another country. Gross national product - GNP, is the total of incomes earned by residents of a country, regardless of where the assets are located. For example, Indias GNP includes profits from Indian-owned businesses located in other countries. 32

Omissions in GDP

Deliberate omissions

There are many things which are not in GDP, including the following.

Transfer payments - For example, social security and pensions.

Gifts. For example, 10 from an aunt on your birthday.

Unpaid and domestic activities. If you cut your grass or paint your house the value of this productive activity is not recorded in GDP, but it is if you pay someone to do it for you.

Barter transactions. For example, the exchange of a sack of wheat for a can of petrol.

Second-hand transactions. For example, the sale of a used car (where the production was recorded in an earlier year).

Cont

33

Intermediate transactions. For example, a lump of metal may be sold several times, perhaps as ore, pig iron, part of a component and, finally, part of a washing machine (the metal is included in GDP once at the net total of the value added between the initial production of the ore and its final sale as a finished item).

Leisure. An improved production process which creates the same output but gives more recreational time is recorded in the national accounts at exactly the same value as the old process.

Depletion of resources. For example, oil production is recorded at sale price minus production costs and no allowance is made for the fact that an irreplaceable part of the nation's capital stock of resources has been consumed.

Environmental costs. GDP figures do not distinguish between green and polluting industries.

Cont

34

Allowance for non-profit-making and inefficient activities. The civil service and police force are valued according to expenditure on salaries, equipment, and so on (the appropriate price for these services might be judged to be very different if they were provided by private companies).

Allowance for changes in quality. You can buy very different electronic goods for the same inflation-adjusted outlay than you could a few years ago, but GDP data do not take account of such technological improvements.

35Unrecorded transactions GDP may under-record economic activity, not least because of the difficulties of keeping track of new small businesses and because of tax avoidance or evasion. Deliberately concealed transactions form the black, grey, hidden or shadow economy. This is largest at times when taxes are high and bureaucracy is heavy. Estimates of the size of the shadow economy vary enormously. For example, differing studies put America's at 4-33, Germany's at 3-28 and Britain's at 2-15. What is agreed, though, is that among the industrial countries the shadow economy is largest in Italy, at perhaps one-third of GDP, followed by Spain, Belgium and Sweden, while the smallest black economies are in Japan and Switzerland at around 4 of GDP. The only industrial countries that adjust their GDP figures for the shadow economy are Italy and America and they may well underestimate its size. 36Expenditure The expenditure measure of GDP is obtained by adding up all spending consumption (spending on items such as food and clothing) investment (spending on houses, factories, and so on) total domestic expenditure exports of goods and services (foreigners' spending) total final expenditure - imports of goods and services (spending abroad) GDP 37Government consumption - The level of government spending reflects the role of the state. Government consumption is generally 10-20 of GDP, although it is higher in countries such as Denmark and Sweden where the state provides many services. Changes in government spending tend to reflect political decisions rather than market forces. Private consumption - This is also called personal consumption or consumer expenditure. It is generally the largest individual category of spending. In the industrialised countries, consumption is around 60 of GDP. The ratio is much higher in poor countries which invest less and consume more. Cont 38Investment - Investment is perhaps the key structural component of spending since it lays down the basis for future production. It covers spending on factories, machinery, equipment, dwellings and inventories of raw materials and other items. Investment averages about 20 of GDP in the industrialised countries, but is nearer 30 of GDP in East Asian countries. 39

Income

The income measure of GDP is based on total incomes from production. It is essentially the total of

wages and salaries of employees

income from self-employment

trading profits of companies

trading surpluses of government corporations and enterprises

income from rents.

These are known as factor incomes. GDP does not include transfer payments such as interest and dividends, pensions, or other social security benefits. The breakdown of incomes sheds additional light on economic behaviour because it is the counterpart to expenditure in what economists call the circular flow of money. It also provides a useful basis for forecasting inflation.

40Unemployment Labour force or workforce - The number of people employed and self-employed plus those unemployed but ready and able to work. Three factors affect the size of the labour force population, migration and the proportion participating in economic activity. Population. Birth rates in most industrial countries fell to replacement levels or lower in the 1980s. This implies an older workforce and higher old-age dependency rates (the number of retired people as a percentage of the population of working age) in the future. By 2010, 15-20 of the population in industrial economies will be over 65 years of age. Cont 41Developing countries have young populations with up to 50 under 15 years. This suggests an expanding working-age population with potential problems for housing and job creation. Migration. In the industrial countries inflows of foreign workers increased since the late 1980s and a substantial number of illegal immigrants were granted amnesty in America, France, Italy and Spain. Foreign-born persons account for over 5 of the labour force in America, Germany and France around 20 in Switzerland and Canada and over 25 in Australia. Inward migration may be a bonus for some economies. For example, German unification boosted that country's productive potential. However, large numbers of refugees seeking asylum can have significant adverse effects on income per head. Cont. 42Wealthier developing countries, especially oil producers, have large proportions of foreigners in their labour forces. Workers frequently make a substantial contribution to the balance of payments in their home countries by remitting savings from their salaries. Participation. Participation rates (the labour force as a percentage of the total population) generally increased in the 1980s and 1990s with earlier retirement for men, especially in France, Finland and the Netherlands, generally offset by more married women entering the labour force, especially in America, Australia, Britain, New Zealand and Scandinavia. Women account for a smaller proportion of the workforce in Muslim countries (20) and a greater proportion in Africa (up to 50) where they traditionally work on the land. Cont 43The unemployment rate. Usually defined as unemployment as a percentage of the labour force (the employed plus the unemployed). National variations are rife Germany excludes the self-employed from the labour force Belgium produces two unemployment rates expressing unemployment as a percentage of both the total and the insured labour force. By changing the definition, which governments are inclined to do, the unemployment rate can be moved up or, more usually, down by several percentage points. 44The Balance Of Payments Accounting conventions Balance of payments accounts record financial flows in a specific period such as one year. Financial inflows are treated as credits or positive entries. Outflows are debits or negative entries. When a foreigner invests in the country, there is a capital inflow which is a credit entry. Conversely, the acquisition of a claim on another country is a negative or debit entry. Debits credits. The accounts are double entry, that is, every transaction is entered twice. For example, the export of goods involves the receipt of cash (the credit) which represents a claim on another country (the debit). By definition, the balance of payments must balance. Debits must equal credits. Current capital. One side of each transaction is treated as a current flow (such as a receipt of payment for an export). The other is a capital flow (such as the acquisition of a claim on another country). Arithmetically current flows must exactly equal capital flows. 45Balances The accounts build up in layers. Balances may be struck at each stage. What follows reflects the IMF'S methodology in the fifth edition of the Balance of Payments Manual Net exports of goods (exports of goods less imports of goods) the visible trade or merchandise trade balance net exports of services (such as shipping and insurance) the balance of trade in goods and services net income (compensation of employees and investment income) net current transfers (such as payments of international aid and workers' remittances) the current-account balance (all the following entries form the capital and financial account) Cont 46 net direct investment (such as building a factory overseas) other net investment (such as portfolio investments in foreign equity markets) net financial derivatives other investment (including trade credit, loans, currency and deposits) reserve assets (changes in official reserves), sometimes known as the bottom line overall balance net errors and omissions zero Cont 47Thus the current account covers trade in goods and services, income and transfers. Non-merchandise items are known as invisibles. All other flows are recorded in the capital and financial account. The capital part of the account includes capital transfers, such as debt forgiveness, and the acquisition and/or disposal of non-produced, non-financial assets such as patents. The financial part includes direct, portfolio and other investment. The balance of payments must balance. When we talk about a balance of payments deficit or surplus, we mean a deficit or surplus on one part of the accounts. 48Fiscal Indicators Fiscal indicators are concerned with government revenue and expenditure. Level of government - Various problems of definition arise because of different treatment of financial transactions by central government, local authorities, publicly owned enterprises, and so on. In an attempt to standardise, international organisations such as the OECD focus on general government, which covers central and local authorities, separate social security funds where applicable, and province or state authorities in federations such as in North America, Australia, Germany, Spain and Switzerland. There is scope for manipulation, Spending can be shifted to publicly owned enterprises which are generally classified as being outside general government. Net lending to such enterprises is part of government spending, but it is not always included in headline expenditure figures. Cont 49

Classification

Public spending may be classified in several different ways.

By level of government central and local authorities, state or provincial authorities for federations, social security funds and public corporations.

By department agriculture, defence, trade, and so on.

By function such as environmental services, which might be provided by more than one department.

By economic category current, capital, and so on.

Breaking down the economic effect of public spending into current and capital spending is a useful way to interpret it.

Cont.

50

Current spending

Major categories of current spending include the following.

Pay of public-sector employees this generally seems to rise faster than other current spending.

Other current spending on goods and services such as stationery, medicines, uniforms, and so on.

Subsidies on goods and services such as public housing and agricultural support.

Social security including benefits for sickness, old age, family allowances, and so on social assistance grants and unfunded employee welfare benefits paid by general government.

Interest on the national debt.

Cont

51

Taxes

Taxes can be Progressive or regressive

Progressive taxes take a larger proportion of cash from the rich than from the poor, such as income tax where the marginal percentage rate of tax increases as income rises.

Proportional taxes take the same percentage of everyone's income, wealth or expenditure, but the rich pay a larger amount in total.

Regressive taxes take more from the poor. For example, a flat rate tax of Rs. 5000, takes a greater proportion of the income of a lower-paid worker than of a higher-paid worker.

Cont

52Indirect taxes. Levied on goods and services, these include the following Value-added tax (VAT) charged on the value added at each stage of production this amounts to a single tax on the final sale price. Sales and turnover taxes which may be levied on every transaction (for example, wheat, flour, bread) and cumulate as a product is made. Customs duties on imports. Excise duties on home-produced goods, sometimes at penal rates to discourage activities such as smoking. Indirect taxes tend to be regressive, as poorer people spend a bigger slice of their income. They are charged at either flat or percentage rates. Cont 53Budget deficits (spending exceeds revenues) boost total demand and output through a net injection into the circular flow of incomes. As with personal finances, a deficit on current spending may signal imprudence. However, a deficit to finance capital investment expenditure helps to lay the basis for future output and can be sustained so long as there are private or foreign savings willing to finance it in a non-inflationary way. Budget surpluses (revenues exceed expenditure) may be prudent if a government is building up a large surplus on its social security fund in order to meet an expected increase in its future pensions bill as the population ages. Tighter or looser. Fiscal policy is said to have tightened if a deficit is reduced or converted into a surplus or if a surplus is increased, after taking into account the effects of the economic cycle. A move in the opposite direction is called a loosening of fiscal policy.

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